While not for the faint of heart, trading options can put some green in your wallet. Options allow the buyer to make money if in a set period of time a stock falls below a predetermined strike price, called a put, or if it rises against the strike price, known as a call. You have to pay for the right, but not the obligation, to exercise options, though, and if the stock price doesn't move enough in the right direction, you'll be out the cost of the options. Some traders buy options; others "write" them and collect the premiums. Writing options is one way to make consistent returns, but carries some risks you need to take into account.
Find stocks unlikely to move beyond the strike price. To reap the maximum profit (premium) from the options you write, the underlying stock must not surpass the option's strike price. Ideally, this means writing options in stocks which are unlikely to move, or will move in your favor. For example, if you believe a stock will rise or stay flat, you want to write a put option. If you think a stock will fall or stay flat, you'll write a call option. If you are correct, the option will expire worthless and you will retain the entire premium paid to you.
Write options that are outside of the current market price of the underlying stock. Consistent returns come from the options you write that expire worthless. To increase your odds of this occurring, select a strike price below the current market price of a stock when writing puts. When writing a call option, the strike price should be above the current market price of the underlying stock.
Protect yourself when writing call options in case the strike price of your options is exceeded. If the stock reaches or exceeds the strike price, you'll be looking at losses and the potential obligation to deliver shares to the buyer of the option. You can cover yourself by buying an equivalent amount of stock for each call option you write -- called a "covered call." If the stock's price drops, you can sell the stock and keep the premium. If the price rises, you can keep the stock and close out of the option, or keep the premium and let your stock be called away. One strategy is to write covered calls on stocks you already own. You can continue to do this time after time as each option you write expires, as long as you continue to own the stock.
- Writing covered call options is usually superior to writing covered put options, as covered puts require the trader to be short the underlying stock. This can increase commissions, margin and costs.
- Options with strikes close to the current stock price will yield a higher premium, but are less likely to expire worthless. Options far out of the money -- meaning the strike price is far off the current market price -- will yield a smaller premium but are more likely to expire worthless.
- If you write a covered option and it is exercised, you give up your right to participate in the profits of the underlying asset.
- Commissions and fees are a major factor. Make sure the premium you receive is enough to offset the commissions and fees for writing the option and any stock purchases or sales required.
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